The UK is in the throes of a type of labor unrest not seen in decades. This is seen in the railways, London Underground and British Airways. Teachers and other public sector workers can join us. The explanation is clear. Unexpected inflation leads to losses that everyone wants to recoup. This triggers social conflicts.
Yet if inflation is bad, so is the cure. Unless one thinks it will magically disappear, the way to end entrenched inflation is through a period of below-trend output and rising unemployment. This will be “stagflation” – a combination of high inflation and low growth that lasts for a while and may need more tightening before it ends.
Let’s start with the inflationary process itself: how much is inflation imported and how much is it due to excessive domestic demand?
In the United Kingdom, the price level of goods other than energy and food has increased by 8% over the past two years. The comparable figure in the United States is 10%. In the euro zone, however, it is only 4.7%. This confirms the view that domestic inflationary dynamics in the UK (and US) have been stronger than in most eurozone countries.
The last Economic outlook also shows that the inflationary process is now generalized in the United Kingdom. Thus, the share of goods and services whose annual inflation is above 4% rose from 14% to 66% between April 2021 and April 2022. Finally, the unemployment/number of job vacancies ratio was lower in the first quarter this year in the UK than in the previous two decades. The American situation is similar.
The OECD also expects headline inflation in the UK to remain at 4.7% at the end of next year. Inevitably, then, people will seek to recoup large losses in their standard of living. This means that there will be strong pressure for higher wages. This pressure will be further reinforced by a growing lack of confidence in the Bank of England’s ability or determination to achieve its inflation target. Contrary to what some central banking circles believe, inflation targets are not achieved because they are credible: they are credible because they are achieved. But if wages do catch up with past (and expected) price increases, a new spiral of domestically generated inflation will emerge, partially offsetting any decrease in the rate of imported inflation.
In sum, in countries like the UK and the US, the economy must be weakened enough to eliminate domestic overheating and remove the likelihood of a destructive wage and price spiral.
This raises two questions: how much attenuation will be needed and how will it be delivered?
An optimistic view on the first question is that taking a tiny bit of surplus from the labor market will be enough to eliminate the risk of a domestic inflationary spiral. It seems highly unlikely. Given the reductions in real incomes that have occurred, workers will expect catch-up wage increases and will benefit from them in any reasonably robust labor market. It is likely that unemployment will have to increase substantially if it is to be contained.
The answer to the second question depends on the extent to which such a downturn will occur anyway. The view that this will happen anyway notes the contractionary impact of higher energy and food prices, fiscal tightening (partly because cash limits will bite in real terms), cuts credit growth as confidence deteriorates, asset prices fall, and war in Ukraine. So the UK economy will be forced to slow down directly, but also indirectly, as the global economy has slowed down. The OECD forecast for the UK for next year is for zero growth.
Will it take more than that to bring inflation back to target? Maybe not, especially if, as seems plausible, real growth will be even weaker than expected next year. But the longer this inflation continues, the more difficult it will be to regain the target. Deliberate policy tightening may need to be larger than currently expected.
The market currently expects the Bank of England short rate to peak at around 3% pa from now. This would still be a materially negative rate in real terms, regardless of plausible inflation expectations. It looks like a mouse of a rate, given the magnitude of current and future inflation overshoots.
Central banks made big mistakes, as Mervyn King argued. At present, the Bank, like other central banks, is hoping that very modest tightening will do the trick. If so, it will be because the economy is going to slow down a lot anyway. Bad times lie ahead. The question is how much.
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